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The Ponzi scheme was named after Charles Ponzi, who became notorious for using the fraudulent investment technique in the early 1900s. The recent arrest of Bernard Madoff shows that the Ponzi scheme is alive and well.
A Ponzi scheme is a sham investment operation. Although there are countless variations of fraudulent investment operations, the basic Ponzi scheme involves paying investors very high returns from of the deposits of subsequent investors, instead of paying them from the profit of a legitimate business.
According to the SEC, the Ponzi scheme uses "the 'rob-Peter-to-pay-Paul' principle, as money from new investors is used to pay off earlier investors until the whole scheme collapses." Last week, the SEC charged Bernard L. Madoff and his investment firm, Bernard L. Madoff Investment Securities LLC, with securities fraud for a multi-billion dollar Ponzi scheme that he perpetrated on advisory clients of his firm.
Looking to a Ponzi scheme's investors will not always reveal the fraud. For example, Madoff's victims included well-known people (Stephen Spielberg), Swiss banks, and charitable organizations.
Instead, you can avoid Ponzi Schemes by using these investment guidelines:
1) As with all investments, exercise due diligence in selecting investments and the people with whom you invest.
2) Make sure you fully understand the investment before you invest your money.
3) Get independent investment advice.
4) Look out for investment vehicles that offer "guaranteed profits" and/or "secret" investment formulas. Remember the old adage: If it seems too good to be true, it probably is.